Can Modern Monetary Theory Lead to Full Employment?

Published on 7th May 2019

The crux of Modern Monetary Theory revolves around the simple fact that any government that has sovereignty (and monopoly) over its currency cannot possibly go broke on local debt because they have unlimited access to the money they owe you. The gold standard completely died in the early 1970s, and in this digital era, the state can create money digitally in milliseconds. The state creates demand for its currency by legally ensuring that all employers pay salaries in local currency. All taxes are also paid in local currency. A household has a limited supply of currency and hence needs to make more money or cut spending as the logic goes. The state that has low foreign currency debt and a high degree of sovereignty over its currency is no household. Take Japan for example. It has a debt to GDP of more than 300% with government debt accounting for a large share of this total. Japan has not gone down under because the Japanese government funds its spending in domestic currency and mainly borrows domestically. It has unlimited supplies of Japanese yen because it prints the Yen.

The key here of course is not to have a lot of debt in a foreign currency. The Greeks, the Italians and to a lesser degree the indebted French have a high debt burden but do not have a monopoly on the Euro. Unlike Japan, their default risk is not zero. The bulk of Mauritian debt is denominated in Rupees and is mostly held by domestic players. In fact, a decent share of this total debt is held by public pension funds and related bodies.

In general, the government of country X has an account at its central bank. Governments do not wait for tax revenues to come into their account at the central bank in order to spend it. Yes, net of tax revenues, money is created out of thin air! When the government of a country wants to spend money, it simply debits its account at the central bank and deposits the money available for spending at commercial banks. In turn, the reserves of commercial banks increase as their deposits increase. On the other hand, if the government imposes/increases taxes/fines/levies any entity, then the opposite occurs, i.e. bank reserves decline.

Using this same logic, cutting taxes, i.e. increasing the deficit, leads to increasing bank reserves. Western central banks, including the Bank of Japan, have been buying up all sorts of bonds, government and even corporate (and in the case of Japan, equities too). This, you guessed it, is a way to increasing reserves in a system. In turn Quantitative Easing has been credited with the stabilization of the financial system and of keeping the economy chugging along despite the lack of meaningful structural reforms globally.

Taxes under MMT are not viewed as money raised for spending but as one liquidity management tool and secondly as a way to resolve distortions within the economy (wealth concentration). A fiscal deficit, when mainly financed via the local currency, is just the difference between how much liquidity has been injected into the system versus how much liquidity has been taken out of the system.

How about bond issuances and interest paid on this debt? Theoretically under MMT, the issuance or purchase of bonds by the state is driven by policy considerations. For example, pension funds locally need bonds to match their liabilities, and credit markets need a risk free (yes it is risk free because you print the money) yield curve to price credit risk when creditors lend money to the private sector. Interest rate on government debt is simply income on private savings. The key policy consideration would then be to closely analyse where most of this “income subsidy” in the fiat currency is going and if this leads to wealth concentration, whether targeted taxation can help.

In sum, governments do not need to issue debt when they run a deficit unless they create a self-imposed rule to do so. However, there are many benefits to issuing local currency debt as explained and it is likely to be one of many good liquidity management tools. The Mauritian government can one day default on foreign debt, which is why the level of foreign debt to GDP (and sovereign guaranties) should be kept as low as possible, but it cannot possibly default on its local debt.

Money printing equals inflation?

It is absolutely true to say that money is neutral in the long run. However it is not the money printing that leads to inflation but the spending of that money without any increase in the production (and the factors of production) of these goods and services that leads to inflation. If money printing is misdirected towards stimulating demand without any long term increase in productive capacity of the economy, then Zimbabwe and Venezuela will occur. This concept does not in any way contradict MMT.

The idea of MMT is to run a local currency financed fiscal deficit in schemes that over time help to increase the production function. There are also limits to how large a fiscal deficit a country can run. The binding constraint to running a higher fiscal deficit should simply be the level of inflation above which the cost benefit no longer makes sense. The state should define this level of inflation.

We should also not ignore the fact that the Mauritian economy is currently growing moderately below capacity and that underlying inflationary pressures have been receding accordingly. Under MMT in fact, there is a free lunch at running a higher fiscal deficit as long as what the money is spent on leads to full employment, i.e. until the economy reaches potential. Inflationary pressures would only become apparent should we push demand well above potential output, but given the moderately negative output gap, this is not a concern.

In sum, the idea here is that, yes, we should and can run higher locally driven fiscal deficits as long as we operate below full employment AND NO HIGHER. A rising inflation rate will be a telling sign that we have gone too far. In that scenario, any state that adheres to some form of MMT has multiple tools from taxes to bonds (including the central bank) to drain liquidity from the system. Admittedly, it would be easier for politicians to cut taxes than to increase them, but a whole combination of liquidity draining tools would be at the disposal of the state.

MMT also arguably works better than current mainstream policies when an economy is slowing. Traditionally when an economy experiences a negative output gap, its central bank cuts interest rates in the hope of stimulating demand over a certain horizon. However, if consumer and investor confidence are both low or falling, lower interest rates do not make businesses invest more money because they fear a lower return on investment.

In the case of MMT, governments would run higher deficits to compensate, and they can even provide job guaranty schemes to keep consumption going at a certain pace. In more modern markets, central banks also engage in bond purchases which stimulate financial markets, which helps to stabilise consumer confidence in these markets.

MMT applicable in a developing country?

There are typically three constraints to monetary sovereignty when it comes to developing countries, and all three relate to the exchange rate channel. Firstly, developing countries may not have energy independence, which means that they import their energy, and having local money printing and a free floating currency can create some challenges especially when energy prices rise.

Secondly, and relatedly, many developing countries import food items and cannot afford high inflation should the local currency depreciate. Thirdly, many developing countries’ value added on exports (after importing the raw materials or other capital intensive goods) is low, which means that any potential currency devaluation risk can hurt exports too.

Note that these challenges are still faced by developing countries today without any MMT implementation. Typically central banks in emerging markets try to limit currency depreciations by buying up their local currency and drawing down on their international reserves and also by hiking interest rates, which also hurts GDP real growth.

MMT is no magic wand, but rather than pointing out to its limitations, it would be best to focus on using MMT to have the resources to fund long term investments into renewable energy sources domestically, to have a better agriculture policy and, by having adequate resources, to fund reskilling and hence invest in factors such as human capital that can increase productive capacity in the long term. Achieving and sustaining full employment under MMT

Using the MMT lens, we can now cut the clutter when it comes to the highly politicised economic debates. What has the government been doing right and wrong since 2006 and what can be done to ensure sustainable full employment which by definition does not mean high inflation?

The 2006 tax cuts were a form of liquidity injection into the system. The economy was operating below capacity at that time. The flat tax system was supposed to have been accompanied by mild forms of wealth taxation such as a campment site tax and taxes on the interest earned on savings (note that banks pay interest on savings deposits to customers as a function of what they themselves earn on their liquid reserves via Treasury bills). Unfortunately, because of lobbying, only the tax cuts survived.

Given rising wealth inequality in Mauritius, it remains important for policy makers to consider the use of mild versions of property taxes (or land value taxation) to help fight this trend. The money should be distributed across local government bodies which would help to better serve their communities. Another approach would be the conversion of villages such as Grand Bay or Tamarin into towns. Many villages are as modern as towns in Mauritius, and municipal taxes should be imposed especially in affluent “villages”. This can help fund better community services and reinvigorate local government spending. Note that under MMT, taxes beyond being a liquidity management tool are also good policy to tackle concentrations of this liquidity and inequality in general.

Bank solidarity levies which were imposed made sense in the sense that banks were flooded with liquidity and were seeing rising profits given the tax cut stimulus of the time. Banks also earn a large share of total interest payments on government debt (under MMT interest on the debt is a form of income paid to private savers). This policy made sense. One can simply stop calling it a levy but call it what it is, a tax. Realistically, it appears that politicians have found it easier to increase taxes on banks than on individuals and other non-financial corporates. In effect this is a liquidity draining tool.

The previous and current governments have both increased the Basic Retirement Pension (BRT) with rumours that the incumbent one is planning for yet another increase. As the country ages, consumption growth, which is a major contributor to total growth (from a purely growth accounting perspective), will slow. Given the lack of a well needed immigration policy and given the death of the manufacturing sector as we know it, job guaranty schemes and income subsidies do make sense in Mauritius.

I would argue that a job guaranty scheme, when coupled with re-skilling income support by the government, would make more sense than increasing the BRT. While the government will always be able to pay the BRT in local currency, that does not mean that it is an optimal policy. The reason why a job guaranty scheme or investments towards renewal energy and food security make more sense is that they focus on increasing our currency sovereignty. MMT is only useful if over time spending is focused on increasing the productive capacity of the economy which by definition cannot be inflationary.

The policy of imposing a negative income tax is a mild form of income support which makes sense in Mauritius, but the minimum wage policy has helped to accelerate the death of the local manufacturing sector. Over time, this will force the government to implement re-skilling and job guaranty schemes which require government financing (which cannot be achieved without some form of a MMT lens).

Job guaranty schemes, when coupled with re-skilling support, may help to improve the production function of the economy in the long run, but in the short run, it helps boost consumption spending too. It remains important for the Mauritian government to think out of the box with a MMT lens and focus on job guaranty schemes and income subsidies that reduce the cost of labour so that more things can be produced locally (especially in agriculture and renewable energy).

The evolution of the exchange rate

Since the late 2000s, the real effective exchange rate (REER) of the Rupee has consistently appreciated. While the nominal effective exchange rate (NEER) too has been appreciating over the last 7 years, the Achilles heel of the export sector has been the simple fact that unit labour costs (ULC) have been rising (our compensation of employees driven by government policy has increased faster than labour productivity). The level of the REER (published by European think tank Bruegel) is currently more than 15% above its 20-year average. As the chart showcases, before 2009-2010, while the NEER depreciated, the REER remained relatively stable because

Consumer Price Index differentials and exchange rate movements offset each other. Think about it as the government at that time paid a 5% wage increase that was offset by a currency depreciation (REER measured in ULC terms should be close to CPI method).

This changed after 2010 given rising wage increases and rising inflation rate differentials. The NEER also began to appreciate, leading to a double whammy. It is very clear that the constraint to MMT would be a low level of inflation with the evolution of the REER being an important parameter to consider. In a context of lack of scale, slowing United Kingdom and European growth, increased foreign competition, robotisation, weak capital productivity and already appreciating REER, a minimum wage policy may sound nice but has ensured the acceleration of the end of sunset industries and has hurt other sectors as well, especially already struggling small and medium enterprises.

It would perhaps have been better to provide government funded partial income subsidies to workers earning less than a certain amount as a form of labour subsidy helping to keep the cost of production low versus imposing a minimum national wage fully financed by a private sector that for the most part already has low savings, low free cash flow generation and was already struggling to repair its balance sheet. Companies should only pay labour based on productivity, and beyond this, governments have policy decisions to think about and a role to play.

Money printing cannot finance everything without creating high levels of inflation, which means that there are still choices to make in terms of what is the best policy that over time creates more real assets to go along with all that created money. What many in the left fail to realise is that by pushing for higher wage growth versus productivity growth, we have dealt a big blow to our manufacturing sector and to any sector that employs semi-skilled labour, something which our underfunded and dysfunctional education system seems to be producing a lot of. MMT or not, the reality is that the government will need to provide income support to a large pool of youth and mid-career workers who cannot find jobs or risk more social unrest.

All governments have wanted to build some form of light metro since the early 1990s. Looking ahead, the key for the current metro project is to be able to refinance its debt from foreign to domestic (the project may look good, but what happens if the currency deprecates a lot when debt is in US dollar?), which would increase the cost of debt from the rumoured 3% level to 6-7%. It would then need to ensure that the return on capital employed (ROCE) of such a project over the lifetime of the loan is at least equal to that level (no negative carry at least). While it is true that the importation of construction materials leads to a higher current account deficit which can offset whatever local players gain from this project during the construction phase and be a drag on growth, the key beyond ROCE or cost of debt consideration for the state would be the potential for productivity enhancement led by a more efficient transport system over time. Only time will tell.

The transmission of savings to investment

Both dispensations of government have allowed the savings rate of the economy to decline sharply to a level that is below 10% of GDP despite the fact that rising government borrowing has helped to partly offset this decline (government debt is savings for the private sector and households). While the investment-savings gap remains financed by foreign investment including luxury villa sales, the decline in capital productivity and in capital-to-output ratio points to the simple fact that our policy obsession with real estate (it brings quick money to finance the current account deficit) does not lead to significant gains in productive capacity. After all, selling a villa to a foreigner is not like setting up a productive factory with new technology and know-how even if we call both “investment.”

The biggest challenge is not the savings rate however but the transmission of savings to investment especially when savings are low. Our capital markets need to be deepened further, but more importantly the government has a big role to play as a seed capital provider in the setup of a venture capital and incubator ecosystem in Mauritius. State owned pension funds too have a role to play as they do in developed markets in sustaining the private credit and private equity markets including start-ups. Between vertical integration of large groups, low savings and the lack of access to growth capital (not just plain vanilla bank debt alone as is the case now), it is not an ideal environment for start-ups to thrive in Mauritius.

What better way to create private sector jobs and increase productive capacity than to help develop the private credit and equity markets in Mauritius to truly help to democratize the economy and diversify the source of funding from daddy’s savings and bank debt alone. With growth capital, venture capital support and a policy of small enterprises with export potential to cluster with each other and scale up, Mauritius can boost productive capacity in the long term as long as the management of the entities that provide the growth capital along with private partners is not politically colonized.

Another key element of allowing businesses to grow and bringing new businesses to Mauritius too is to have a formal immigration policy focusing on young entrepreneurs who can create small scale value added jobs over time in Mauritius. The population will start shrinking in the coming decades, and unless we are planning for robots like in Japan, we have no choice but to have a well-designed immigration policy and grow the population.

In conclusion, while MMT is not a magic wand, the concept has been gaining ground over the past two decades, and more importantly, some forms of MMT have already been implemented globally. The Mauritian state as we know it has a monopoly over its own currency and will never run out of Mauritian rupees to pay down its local liabilities as it is not a household and enjoys unlimited supplies of its currency.

Given the moderately negative output gap, there is scope for the government to maintain or moderately increase its fiscal deficit (as long as it is financed locally) in order to get to full employment. Policies that focus on greater income support such as job guaranty schemes, greater investments in reskilling and in education, in renewable energy and in agriculture, when coupled with a sound immigration policy, are key to generating higher growth and can justify a higher fiscal deficit. Beyond being a liquidity management tool, taxation should be viewed as one tool among a wide set of liquidity injecting/draining tools.

A fiscal deficit is not about how much you earn and how much you spend, but about how much net liquidity you put into a system in coordination with all state entities. MMT is not a free lunch, which means that deficits should focus on spending that helps to get the economy to full employment and to increase the productive capacity of the economy in the long run. The cost of running a fiscal deficit then is not measured by interest payments which is again a form of income re-distribution in the fiat currency, but by the potential of the underlying policies to generate inflation (when an economy is above full capacity). The government, however, should certainly constrain foreign borrowings and net foreign liabilities of the whole system when engaging in any form of MMT.

By Sameer Sharma

The author is a chartered alternative investment analyst and a certified financial risk manager.